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The Profitability Of Islamic And Conventional Banks Finance Essay

Sufian (2007) performed a similar study to provide new evidence on the comparative efficiency between Islamic banking operation and local banking operation in Malaysia during the period of 2001-2004. Non-parametric Data Envelopment Analysis (DEA) methodology had been utilized to distinguish between three different types of efficiency, technical, pure technical and scale efficiencies. The study used intermediation approach to specify input-output variables of Islamic banks. A sequence of parametric and non-parametric tests were executed to evaluated whether the local and overseas banks were strained from the similar population, as most of the most of the results could not refused the null hypothesis at 5% level of significance. Finally, Spearman Rho Rank-Order and the Parametric Pearson correlation coefficients were employed to examined the association between the competences scores derived from the DEA results with the traditional accounting ratios. Several results were drawn from the study. The results from the DEA showed that efficiency of Malaysian Islamic banks recovered slightly in years 2003 and 2004 after declining in year 2002. The domestic Islamic banks were found marginally more efficient than foreign Islamic banks. The study examines that operating at the erroneous scale of operations had been the main reason for the Malaysian Islamic banks inefficiency. The governance of scale in influential the technical efficiency of Malaysian Islamic banks was further confirmed from the results of the correlation coefficients. The results studied and also indicated that profitability was significantly and strong positively correlated to all efficiency measures.

Mauro (1995) studied different countries pattern that like Pakistan, Iran and Egypt and found that bribery and practical incompetence in the data that created the unproductive economies and rather high levels of upward economies also did not just Islamic ones.

In these countries, many entrepreneurs’ second-hand funds from their firms for own utilization of gratuity or extravagant, pessimistic return investment. In these scenario agency issues raised which created hurdle in financing of banks.

Bolton and Scharfstein (1990) and Hart and Moore (1998) model arose the issue of agency impasse with the incapability of contractual. In the court law the assumption of cash flow was not consider verifiable the profit of entrepreneur’s. Bolton and Scharfstein (1990), Hart and Moore (1998) utilized the model and created the rule for profit sharing on the basis of their cash flows.

Miller and Noulas (1996) examined the efficiency of large US banks and found overall technical efficiency (TE) of around 97 per cent. However, the majority of banks were found to be too large and experiencing decreasing returns to scale. A second stage regression analysis showed that pure TE was positively related to bank size and bank profitability.

Alirezaee et al. (1998) utilized data from 1,282 bank branches in Canada to conduct numerical research relating to DEA results to sample size and found that the average branch competence score different inversely with the number of branches in the sample and directly with the total number of inputs and outputs and also concerned that using comparatively test sizes in a model with as a small number of as three inputs and three outputs may possibly direct to a extensive rising bias in competence scores.

Seiford and Zhu (1999) examined the performance of the top 55 US banks using a two-stage DEA approach and results indicated that relatively large banks exhibit better performance on profitability, whereas smaller banks tend to perform better with respect to marketability.

Cook and Hababou (2001) examined that both the sales and service efficiencies of bank branches and extended the standard additive DEA modeling approach using goal programming to derive optimal efficiency scores while accounting for shared branch resource inputs.

Drake and Howcroft (2002) reviewed and found that the relative efficiency of UK clearing bank branches using DEA method. This research utilized the basic efficiency indices and extensive the analysis by examining the relationship between size and efficiency.

Yildirim (2002) assessed in 1988 the efficiency of Turkish commercial banks and 1999 using DEA method. Results suggested that over the sample period both pure technical and scale efficiency measured showed a great variation and the sector did not achieve sustained efficiency gains.

Using a bootstrapping DEA technique, Casu and Molyneux (2003) further investigated efficiency across European banking systems and suggest result that there had been a slight improvement in bank efficiency levels since the implementation of the EU's Single Market Program.

Krishnasamy (2003) used both Malmquist total factor productivity index (MPI) and DEA to evaluated bank efficiency and productivity changes in Malaysia over the period 2000-2001. The results from the analysis indicated that total MPI increased in all the bans studied. The development of productivity in these banks was attributed to technological change rather than TE change.

Lo and Lu (2006) studied engaged a two-stage DEA approach including profitability and marketability to explore the efficiency of financial holding companies (FHCs) in Taiwan. Factor-specific dealings and BCC (Banker-Charnes-Cooper) model were united together to recognize the inputs/outputs that were most significant and to differentiate those FHCs which can be treated as yardstick. Results showed that big-sized FHCs were usually more competent than small-sized ones.

Wu et al.(2006) integrated DEA and neural networks (NNs) to examined the relative branch efficiency of a large Canadian bank and found that the predicted efficiency using the DEA-NN model has good correlation with that calculated by DEA, which indicated that the predicted efficiency using the DEA-NN approach was a good proxy to classical DEA approach.

From this brief reviewed and found that although numerous studies had attempted to assess banks efficiency in the West and other parts of the world, very few studies had focused on measuring efficiency in the Arab world. The lack of empirical research in this area confirmed Atiyya's (1992) found concerning the lack of empirical research into Arab management practices in general. In this investigation fill this research gap by empirically evaluating banks efficiency in the Arab world.

Scitovsky (1954) suggested that export produces positive externality whose favorable impact was particularly significant in economic development. Kessing (1967), Bhagwati (1978), and Krueger (1978) argued that openness exposes countries to the most advanced new ideas and a method of production dictated by international competitive behavior and thus enhances efficiency. Through openness, countries manage to overcome the small size constraint of their domestic markets and reap in the process, with the cost advantage of increasing return to scale.

CHAPTER 3

THEORTICAL AND HYPOTHESIS FORMULATION

3.1 Theoretical Hypothesis

Samad (2004), in the post Gulf War period, i.e. 1991-2001, research observed and compared the performance of Bahrain’s interest free Islamic banks and the interest based conventional commercial banks. According to the research there were not much difference between profitability performance of Islamic banks and conventional banks of Bahrain.

Kader and Asarpota (2007) assessed the performance of UAE Islamic banks using the bank level data. To collect the data for the study, balance sheets and income statements of 3 Islamic banks and 5 conventional banks were used during the period 2000-2004. The outcome of the study shows that Islamic banks of UAE are comparatively more profitable than conventional banks of UAE.

Samad (1999) and Hassan (1999) studied also disclosed that conventional banks compared Bank Islamic Malaysia Berhad was not as risky and also more solvent. These results also match with the risk return profile, i.e. Bank Islamic Malaysia Berhad was relatively less profitable and less risky.

Rosly and Baker (2003) In Malaysia studied the profitability of performance of Islamic banking schemes (IBS) banks in comparison with conventional banks of Malaysia and inspected that performance of IBS banks were better, equivalent to or lowers than the performance of the conventional banks.

As per above arguments hence develop the hypothesis.

3.2 Hypothesis Formulation

Ho: Islamic and conventional banks have no similarity in profitability.

3.3 Key Variables

As per available literature following factors have been identified that affect profitability of the two banks: Return on assets (ROA), Return on Equity (ROE), and Profit Expense Ratio (PER).

Return on Assets (ROA)

Return on assets indicates the profitability on the assets of the firm after all expenses and taxes Van Horne (2005) and common measure of managerial performance Ross et al. (2005) measured how much the firm had earning after tax for each dollar invested in the assets of the firm. This measures net earnings per unit of a given asset, moreover, how bank can convert their assets into earnings Samad and Hassan (2000). Generally, a higher ratio means better managerial performance and efficient utilization of the assets of the firm and lower ratio was the indicator of inefficient use of assets. ROA can be increased by firms either by increasing profit margins or asset turnover but can not do through simultaneously because of competition and trade-off between turnover and margin.

Return on Equity (ROE)

Return on equity indicated the profitability to shareholders of the firm after all expenses and taxes Van Horne (2005) and measured how much the firm was earning after tax for each dollar invested in the firm. In other words, ROE was net earnings per dollar equity capital by Samad and Hassan (2000). It was also indicator Ross (1994), Sabi (1996), Hassan (1999), and Samad (1998) of measuring managerial efficiency. By and large, higher ROE means better managerial performance; however, a higher return on equity may be due to debt (financial leverage) or higher return on assets. Financial leverage created an important difference between ROA and ROE in that financial leverage always magnifies ROE. This would always be the case as long as the ROA (gross) was greater the interest rate on debt Ross et al (2005). Usually, there was higher ROE for high growth companies.

Profit to Expenses Ratio (PER)

This measured the operating profitability of the bank with regards to the total operating expenses. In our study, operating profit was defined as earnings before taxes and operating expenses means total non-interest expenses. The ratio measured the amount of operating profit earned for each dollar of operating expense. The ratio indicated to what extent bank was efficient in controlling their operating expenses. A higher PER meant bank was making higher profits and cost efficient by Samad and Hassan (2000).

CHAPTER 4

RESEARCH METHODS

4.1 Sampling Design

This study is conducted on secondary data and collected 8 years data of 21 conventional banks performance of each year 2001-2008 except 6 conventional banks because these banks data are less than eight years and collected 6 full fledge Islamic banks data from different performance years which are as under.

Meezan Bank 1999-2009

Al-Barak, EGIBL, DIB and Dawood 2006-2008

Bank Islami 2004-2008

Moreover, 12 conventional banks have under Islamic banking collected data from different years because these conventional banks started their Islamic banking on different years which are as below:

Standard Chartered Bank, National Bank of Pakistan (NBP), Askari Bank, Bank Al Habib, Habib Metropolitan Bank, and Royal Bank of Scotland and United Bank Limited (UBL) collected data from years of 2007-2009. While Habib Bank, Muslim Commercial Bank, and Soneri Bank from 2008-2009, Bank of Allfah data 2007-2008 and only Faysal Bank data 2009 year.

4.2 Method of Data Collection

Following Sources for Data collections which are mentioned below:

Bank’s Websites

Bank’s website for collect their financial statements for financial data which used in this research work.

Pakistan Banks’ Association

Pakistan banks’ association website collecting the financial statements of members banks which utilized in this work.

State Bank of Pakistan

State Bank of Pakistan web site and personal visit for collect the information about total assets, operating expense, profit before tax, and profit after tax and share holder equity to calculate the profitability of banking sector

4.3 Methodology

To evaluate the performance of Islamic and conventional banks in the Pakistan since Independent t-test is used to compare of two means and performance of the banking. Using accounting ratios to measure performance, financial ratios have been used quite commonly and extensively in the literature. For example, bank regulators use financial ratios to evaluate bank’s performance E.g. (Samad (1999), Samad and Hassan (2000), Meister and Elyasiani (1988), Spindler (1991), Akkas (1994), Sabi (1996), Ali and Rami (2006) gave employed ratios for evaluating a bank’s performance. The most important benefit was that it compensates bank disparities. Banking firms were not equal with respect to sizes. The use of ratio removes the disparities in sizes and brings them at par.

4.4 Statistical Technique

The statistical techniques of T-test were used to explore the comparison of profitability of Islamic banks and conventional banks.

CHAPTER 5

RESULTS

This chapter consisting of 2 tables, Table 5.1 represents the group statistics of conventional banks and Islamic banks, Table 5.2 describes independent sample test,and Table 5.3 hypothesis assessment summary

5.1 Interpretation of Group Statistics

Table 5.1: Group Statistics

Group Statistics

Islamic Vs Conventional

N

Mean

Std. Deviation

Std. Error Mean

Return on Asset Before Tax

Islamic Banking

55

.010094

.0408207

.0055043

Conventional Banking

167

.016896

.0238656

.0018468

Return on Asset After Tax

Islamic Banking

25

.008034

.0283759

.0056752

Conventional Banking

167

.011562

.0172583

.0013355

Return on Equity Before Tax

Islamic Banking

38

-2.1402

1.09788

.17810

Conventional Banking

153

-1.3899

1.01827

.08232

Return on Equity After Tax

Islamic Banking

15

-2.6619

1.08335

.27972

Conventional Banking

152

-1.7368

.89974

.07298

Price to Expense Ratio Before Tax

Islamic Banking

55

.550955

2.8981245

.3907830

Conventional Banking

167

.965471

2.4642851

.1906921

Price to Expense Ratio After Tax

Islamic Banking

25

.464958

1.5104095

.3020819

Conventional Banking

167

.681080

1.8476879

.1429784

The output from the t-test by looking at the table above indicates the mean values on the variable for the two different groups and apply the log on ROE. Here see that return on asset before tax 55 sample of Islamic banking have an average of .0109 while 167 sample of conventional have an average of .0169 while return on asset after tax 25 sample of Islamic banking have an average of .008 while 167 sample of conventional have mean .0115.

Secondly, return on equity before tax 38 sample of Islamic banking have an average of -2.1402 while 153 sample of conventional have an average of -1.3899 while return on asset after tax 15 sample of Islamic banking have an average of -2.6619 while 152 sample of conventional have mean -1.7368.

Finally, price to expense before tax 55 sample of Islamic banking have mean of .5509 while 167 sample of conventional have an average of .9654 while price to expense ratio after tax 25 sample of Islamic banking have an average of .4649 while 167 sample of conventional have a mean .6810.

5.2 INTERPRETATION OF INDEPENDENT SAMPLE TEST

Independent Samples Test: Table 5.2

Independent Samples Test

Levene's Test for Equality of Variances

t-test for Equality of Means

95% Confidence Interval of the Difference

F

Sig.

t

df

Sig. (2-tailed)

Mean Difference

Std. Error Difference

Lower

Upper

Return on Asset Before Tax

Equal variances assumed

12.191

.001

-1.511

220

.132

-.0068026

.0045026

-.0156763

.0020710

Equal variances not assumed

-1.172

66.568

.245

-.0068026

.0058058

-.0183925

.0047872

Return on Asset After Tax

Equal variances assumed

4.987

.027

-.865

190

.388

-.0035282

.0040798

-.0115757

.0045193

Equal variances not assumed

-.605

26.720

.550

-.0035282

.0058302

-.0154966

.0084402

Return on Equity Before Tax

Equal variances assumed

.747

.388

-4.002

189

.000

-.75031

.18747

-1.12012

-.38050

Equal variances not assumed

-3.824

53.900

.000

-.75031

.19621

-1.14369

-.35692

Return on Equity After Tax

Equal variances assumed

1.403

.238

-3.729

165

.000

-.92512

.24811

-1.41500

-.43525

Equal variances not assumed

-3.200

15.964

.006

-.92512

.28908

-1.53807

-.31218

Price to Expense Ratio Before Tax

Equal variances assumed

2.435

.120

-1.034

220

.302

-.4145158

.4007218

-1.2042606

.3752290

Equal variances not assumed

-.953

81.280

.343

-.4145158

.4348274

-1.2796408

.4506092

Price to Expense Ratio After Tax

Equal variances assumed

.033

.856

-.557

190

.578

-.2161215

.3878421

-.9811510

.5489079

Equal variances not assumed

-.647

35.699

.522

-.2161215

.3342100

-.8941296

.4618865

Table 6.2 displays the results of the independent sample test that SPSS conducts to t-test whether or not the difference between the two sample means is significantly different from zero (null hypothesis the groups banks have not similar in profitability).

The confidence interval of 95% of the difference provides an estimate of the boundaries of the difference between which the mean difference lies in 95% of all possible random samples of 21 conventional banks, 6 full fledge banks and 12 conventional banks have under Islamic banking.

Return on Asset before Tax Result

The significance value of Levene’s test for equality of variance F value is 0.01 which is less than at 5% or 0.05 that is significance level. Therefore variance of Islamic bank is not equal to variance of conventional banks. In the section of “Equal variances not assumed”, t-value is 0.245 which greater than at 5% or 0.05 significance level, therefore both Islamic and conventional banks return on asset before tax is same.

Samad (2004) applied the t-test and predicted that there was no significant difference of return on assets before tax (ROA) between conventional and Islamic banks in Bahrain.

Return on Asset after Tax Result

The significance value of Levene’s test for equality of variance F value is 0.027 which is less than at 5% or 0.05 that is significance level. Therefore variance of Islamic bank is not equal to variance of conventional banks. In the section of “Equal variances not assumed”, t-value is 0.55 which is greater than at 5% or 0.05 that is significance level, therefore both Islamic and conventional banks Return on Asset after Tax is same.

Samad (2004) predicted the there was no significant difference of return on assets after tax (ROA) between conventional and Islamic banks in Bahrain.

Return on Equity before Tax Result

The significance value of Levene’s test for equality of variance F value is 0.163 which is greater than at 5% or 0.05 that is significance level. Therefore variance of Islamic bank is equal to variance of conventional banks. In the section of “Equal variances not assumed”, t-value is .004 which is less than at 5% or 0.05 significance level, therefore both Islamic and conventional banks Return on Equity before Tax is not same.

Abdus Samad (2004) predicted the there was no significant difference of return on assets after tax (ROE) between conventional and Islamic banks in Bahrain.

Return on Equity after Tax Result

The significance value of Levene’s test for equality of variance F value is 0.388 which is greater than at 5% or 0.05 that is significance level. Therefore variance of Islamic bank is equal to variance of conventional banks. In the section of “Equal variances not assumed”, t-value is .000 which is less equal to 5% or 0.05 significance level, therefore both Islamic and conventional banks Return on Equity After Tax is not same.

Profit Expense Ratio before Tax Result

The significance value of Levene’s test for equality of variance F value is 0.238 which is greater than at 5% or 0.05 that is significance level. Therefore variance of Islamic bank is equal to variance of conventional banks. In the section of “Equal variances not assumed”, t-value is 0.006 which is less than at 5% or 0.05 significance level, therefore both Islamic and conventional banks Profit Expense Ratio Before Tax is not same.

Profit Expense Ratio after Tax Result

The significance value of Levene’s test for equality of variance F value is 0.856 which is greater than at 5% or 0.05 that is significance level. Therefore variance of Islamic bank is equal to variance of conventional banks. In the section of “Equal variances not assumed”, t-value is 0.522 which is greater than at 5% or 0.05 significance level, therefore both Islamic and conventional banks Profit Expense Ratio After Tax is same.

Overall result showed that Islamic and conventional banks have difference therefore, accept our null hypothesis with a view that both Islamic and conventional banks have not similar in profitability.

Table 5.3 Hypothesis Assessment Summary

Hypothesis

F

Sig.

t

df

Sig. (2-tailed)

Empirical Conclusion

H1: Islamic and conventional banks have no similarity in profitability

12.191

.001

-1.511

220

.132

-1.172

66.568

.245

Accept

4.987

.027

-.865

190

.388

-.605

26.720

.550

Accept

.747

.388

-4.002

189

.000

-3.824

53.900

.000

Reject

1.403

.238

-3.729

165

.000

-3.200

15.964

.006

Reject

2.435

.120

-1.034

220

.302

-.953

81.280

.343

Accept

.033

.856

-.557

190

.578

-.647

35.699

.522

Accept

CHAPTER 6

IMPLICATIONS,FUTURE RESEARCH AND CONCLUSION

6.1 Implications

The study examined that Islamic banking is playing key role in financing and promoting the different economic and social sector activities with the philosophy of Islamic Shariah in Islamic banking practices .On the other hand conventional banks are backed by longer and dynamic history, unique position and also promote the social and economical activities in Pakistan so in this way competition arises between Islamic and conventional banking to promote the social and economical activities within Pakistan. Therefore, conventional banks are starting Islamic banking to promote the banking industry It is predicted that the competition will arise to extend in the coming time where both the banks will competition will be head.

The study provides insight about the performance in terms of profitability Islamic banking in comparison to conventional banking in the country so the results indicated that Islamic banks profitability are not equal to conventional banks because Islamic banking concept itself is new in the economy as compared to the conventional banking. So there is still a margin for the Islamic banking to grow and expand accordingly in the different sectors depending upon their unique services offering and enhanced services in the field of banking.

On the brighter side the banking industry is still lucrative and can attract different numbers of banks irrespective of the convention they use. So due to the emerging trends in the global and local banking systems the key to survival is to offer top the notch products and services to the customers. Banks have to be more flexible, dynamic and efficient in their offering as well as processes.

6.2 Recommendations

This research can also be applied in different sectors to determine the profitability in the local economy with segments like cement sector, sugar sector, and pharmaceutical etc.

This research is beneficial and gives an insight regarding the investment, financing and strategic guidance for depositors, investors, creditors to know the bank’s performance as well as about the functionality and creditability of both Islamic and conventional banks profitability.

Bottom line is that if the banks need to survive in the competitive world banks have to create a unique selling proposition in order to compete with the other banks. The techniques and methods that we have discussed can also be customized for the different industry and sector of the Pakistan economy.

The report not only comprehend the different convention of the banking industry being practiced in Pakistan but it can also prove handful in the bigger picture of the economy and different parameters can be used accordingly for the quantitative as well as qualitative analysis.

6.3 Conclusion

Examination of the empirical analysis makes it possible for us to shed some light on our findings and draw some conclusions. Our analysis of profitability measures indicates that conventional banks are more profitable and are significantly different from Islamic bank in Return on Equity (ROE). However, conventional banks are not significantly different from their counterpart in terms of Return on Asset (ROA) and Price to Expense Ratio (PER). Further analysis of ROE reveals that Islamic bank is getting closer to conventional banks in an upward trend; it is not inconceivable that in the near future that Islamic bank might outperform the conventional banks. Moreover, in a separate study of one to one comparison of each of conventional bank in the group with Islamic bank reveals that Islamic bank outperforms some of the conventional banks in the selected group. Overall, ROE is found rising for Islamic bank and plummeting for the conventional banks mainly due to the difference in equity base and profit level of the banks. The study found that conventional banks are more profitable and also more competent comparing to the average of the Islamic banks. The facts that Islamic banks in Pakistan have no longer history and do not hold lead pose in the pecuniary division with its small share in the taken as a whole financial possessions of Pakistan, as compared to conventional banks the ratio is still lagging behind that of conventional banks. Analysis of efficiency measures further strengthens our finding.

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